Batman and Robin. Sandberg and Dunston. Vaughn and Favreau. The reducing revolver and the loan sweep. Jordan and Pippen. Each great in their own right, yet legendary together.
Yep, I know what you’re thinking. Vaughn and Favreau, really?
Unfortunately, to most business owners, the lesser known of these combos is the reducing revolver and the loan sweep. They have the potential to help many small businesses save thousands of dollars per year.
What’s a Loan Sweep?
The loan sweep is an automated service that simply takes excess account balances over a target (or peg) balance and automatically “sweeps” that otherwise idle cash each day to pay down loan balances. In most cases, the sweep helps pay off a customer’s revolving line of credit—a revolver, for short.
Often the target balance is an agreed-upon balance that the borrower and banker set based on the borrowing rates in correlation
to earnings credit rates on commercial
deposit accounts.
Operating cash pays down the revolver, and conversely, when the operating account runs low, the revolver can help fund the operating account. The borrower/depositor simply follows the activity online.
Depending on the amount swept against the revolver, the borrower can save tremendously. There is a small fee for the sweep service, but it usually costs only a fraction of what can be saved by using deposits to offset revolving loan balances.
How the Reducing Revolver Works
Most revolving lines of credit are used to fund routine working-capital needs, but they can also be structured to include long-term fixed assets like equipment and real estate.
Unlike a normal revolver, the amount of a “reducing revolver” will be periodically reduced, either annually or quarterly, to mimic the normal amortization schedule for a fixed-asset loan. A reducing revolver can also continue to be used for short-term working capital, even as the borrower pays off the fixed asset.
It all comes together when the loan sweep is put in place. The sweep will use excess funds from a company’s operating account to pay down whatever’s owed on the fixed asset and the working capital—while still accommodating the fluctuating, day-to-day need for operating cash.
Case Study No. 1 Making the Double Play
The owners of Double Play Inc. have set up a separate entity, Clark & Addison LLC, to own and lease a building back to the operating company.
Double Play, the operating company, is flush with cash, but the building entity, Clark & Addison, has a reducing-revolver mortgage of $4.5 million with a 5 percent interest rate. At the suggestion of their banker, the owners decide to sweep the excess balances currently in Double Play’s operating account to pay down the higher rate on the mortgage of Clark & Addison LLC.
The owners are comforted by knowing that, if they need money for operations, they can access whatever advance principal payments they’ve made on the unamortized portion of the building’s mortgage.
Meanwhile, the owners continue to save on the reduced principal. After all, interest costs are based on outstanding borrowings, and the revolver reduces each year in line within a set amortization schedule.
Over the course of the last year, Clark & Addison’s reducing-revolver mortgage benefited from a daily average of $500,000 of balances being swept from the Double Play operating account, creating a gross annual savings of $25,000.
Case Study No.2 Bases Loaded and Covered
Bases Loaded Inc. has funding needs of $2 million for equipment it recently purchased, and the company has historically relied on a $3 million revolver for working capital. Combine those two, and Bases Loaded has a reducing revolver equal to $5 million.
At the advice of their banker, the company’s owners decide to sweep deposit balances against the combined debt for the equipment purchases and working capital.
The portion of the revolver used to fund the equipment purchases will fully amortize over five years. Meanwhile, cash is automatically swept back and forth between the operating account and the revolver to meet the company’s cash flow needs.
The average outstanding balance on the reducing revolver was reduced by an average of $400,000 that was swept daily from the operating account. At 5 percent, this provides a gross savings of $20,000 annually.
The chart on Page 34 shows how the reducing revolver would evolve over the course of five years.
If you’re interested in this strategy, you’ll need to work with your banker to ensure you both have a clear understanding of your cash flow, your working capital needs and your capital expenditure requirements.
The potential could be huge for your company. Using the reducing revolver and the loan sweep might be among the most fruitful cost-saving exercises your company ever undertakes.
